Elasticity
Elasticity is part of the IB Syllabus for microeconomics. Price Elasticity of Demand • Formula : E_d = \frac{\%\ \mbox{change in quantity demanded}}{\%\ \mbox{change in price}} = \frac{\Delta Q_d/Q_d}{\Delta P_d/P_d} • Definition The price elasticity of demand measures the responsiveness of the demand of a good to a change in the price of another good!!! • Possible range of values *If Ped = 0 then demand is perfectly inelastic. This means that demand does not change at all when the price changes – the demand curve will be vertical *If Ped is between 0 and 1 then demand is inelastic. Producers know that the change in demand will be proportionately smaller than the percentage change in price *If Ped = 1 , then demand is said to be unit elastic. A 25% rise in price would lead to a 25% contraction in demand leaving total spending by the same at each price level. *If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example a 10% increase in the price of a good might lead to a 20% drop in demand. The price elasticity of demand for this price change is –1.5 • Diagrams illustrating the range of values of elasticity Values for price elasticity of demand can range from 0 (Figure 1) to infinity (Figure 2). If PED is 0, the quantity of demand will not change no matter how much price shifts. If PED is infinity, price remains constant no matter how the quantity changes. • Varying elasticity along a straight-line D curve http://upload.wikimedia.org/wikipedia/commons/1/1c/Price_elasticity_of_demand_and_revenue.svg which can be found on the link above. • Determinants of price elasticity of demand 1. Number of close substitutes for a good and the quality/rarity of the product. 2. Cost of switching between different products. 3.Time period alotted for following a change in price. 4. Rarity of the good or the degreee of necessity. 5. Percentage of a consumer's income allocated to spend on the good. Cross Elasticity of Demand • Definition The cross elasticity of demand measures the reactiveness of demand for one good from a change in the price of another good! • Formula PEDx,y = % change Q of x / % change P of Y 700,000= Q of x and 500,000= Q of x 700,000-500,000/500,000= 2/5 • Significance of sign with respect to complements and substitutes: If the cross elasticity of demand is positive, the two goods being compared are substitutes, if it is negative, they are compliments. If the absolute value of the cross elasticity of demand is more than one, the relationship between the goods is strong, if it's less than one, they are weak. Income Elasticity of Demand • Definition *Income Elasticity of Demand measures the demand of goods when people's income are changing for demanding of goods. Income Elasticity of Demand is quantifed with the formula % change of quantity of demand / % change in real income. Income Elasticity of Demand referrers to inferior and normal goods that shows the diffrence between necessary goods and a luxury or superior goods. • Formula • Normal goods: *Normal goods are goods for which demand increases when income also increases, and then falls when income decreases, but the price is always the same. A normal good also has an income elasticity of demand that is positive, but is less than one. It is the opposite of an inferior good. • Inferior goods: *an inferior good is a good that decreases in demand when consumer income rises, unlike Normal Goods, for which the opposite is observed. Normal goods are those for which consumers' demand increases when their income increases. Inferiority, in this sense, is an observable fact relating to affordability rather than a statement about the quality of the good. As a rule, too much of a good thing is easily achieved with such goods, and as more costly substitutes that offer more pleasure or at least variety become available, the use of the inferior goods diminishes. Depending on consumer or market indifference Curves, the amount of a good bought can either increase, decrease, or stay the same when income increases. Price Elasticity of Supply • Definition:The extent to which supply responds to a change in the price of goods or services. As a general rule, if prices rise, then so will supply (proportionate change in price to proportionate change in supply). The more elastic, the more sensitive price is and vise versa. • Formula PES= %change Q supplied / % change in price • Possible range of values • Diagrams illustrating the range of values of elasticity • Determinants of price elasticity of supply Necessities vs. Luxuries - Because necessities are goods that people need to consume, they tend to have an inelastic demand. This means that when the price of a necessity rises, quantity demanded for the necessity does not change much. Luxuries are not goods that people need (people just consume them if they are able). Because of this, an increase in the price of a luxury tends to be associated with a large decrease in the quantity demanded for the luxury. Economists usually find that luxuries have elastic demand. Availability of Close Substitutes - Products that have readily available substitutes tend to have elastic demand. This is because consumers will switch to the available substitute when the price of the product rises, causing a large decrease in quantity demanded. When products dont have readily available substitutes, consumers are not able to switch when the price of the product rises and so a decrease in quantity demanded will be smaller. Products without readily available substitutes tend to have more inelastic demand. Time Horizon - Most products have more elastic demand over a longer period of time. The reason is that more substitutes will become available in the future than are currently available. Also, people may change their consumption behavior in the future. Definition of the Market - The more broadly we define an item, the more possible substitutes and the more elastic the demand. A jet powerd, six setting shower head is more inelastic then bathroom acceseries. Application of Concepts of Elasticity • PED and business decisions: the effect of price changes on total revenue PED is an indicator of the total revenue for a business. The total revenue is the product of the quantity and price of a good (P*Q), and since PED relates the percent changes in these quantities, they are strongly related. On a demand curve, any point with a PED of exactly 1 (that is, unit elastic) in every direction to any other other point is a point of maximum revenue. This means that at a point that is unit elastic in all directions, any direction you move will you give you a point with lesser (or equal) total revenue. • PED and taxation: • Cross-elasticity of demand: relevance for firms • Significance of income elasticity for sectoral change (primary to secondary to tertiary) as economic growth occurs • Flat rate and ad valorem taxes • Incidence of indirect taxes and subsidies on the producer and consumer • Implication of elasticity of supply and demand for the incidence (b urden) of taxation Category:Microeconomics